Aon plc. - Class A (AON) — Q2 2018 Earnings Call Transcript

Thanks, Shaun, and good morning, everyone. Welcome to our second quarter 2018 conference call. Joining me today is our CFO, Christa Davies. After many conference calls, we’re excited to introduce a new approach today, all intended to be hopefully more helpful for all of you. Christa and I would like to start by highlighting how our colleagues around the world delivered a strong result in Q2 and the first half of the year, reinforcing the continued momentum we talked about in the first quarter call as well. Beginning on today's call, what we plan to do is post for you a comprehensive standalone document that provides both financial backup and a commentary on our strategic priorities, and really how our plans are producing results. And we're confident you will let us know how we can improve this new approach, but we really want to make sure you know what our intent is here: a broader-based conversation. Fundamentally, the document we posted is meant to provide all that we’d have covered in our initial commentary and more. As a result, we plan to use our time on the call to provide a little more insight into the longer-term view for the firm. This approach will also allow us to describe two or three investment or growth areas that we think are strengthening our capability to serve clients fundamentally and hopefully, you get the idea. We hope to give you a better insight into Aon and important areas around our firm, like our journey to deliver Aon United. That's really a perfect place to start a discussion today. The idea of Aon United at scale and the benefits that accrue when our global firm works together effectively are substantial. It's not something we've historically covered on this call, but nonetheless, it's a very important piece of our long-term success and a real growing strength of Aon. You'll see we took significant steps over the last quarter to build on that strength, executing our announced changes to deliver more consistent value propositions that we know our clients like and are demanding more and more. This is really about how we make available to them the global capability of our firm, tailored to them, fully suiting their business needs and objectives. We are bringing together the capability of Aon against client needs in a very broad-based way; it is highly effective, powerful, and meaningful. We call this leading Aon United. More specifically, you saw the thinking and the commitment reflected in our May 15 announcement, which described a number of these changes, all designed to make it easier to bring the best of the firm to our clients. So you saw we’re moving around leadership. We established co-presidents, Eric Anderson and Mike O'Connor, two great colleagues in the firm who will be wonderful in these roles. They will also be overseeing a new global Aon Operating Committee, which includes direction of global business services, all reinforcing the single P&L we announced in 2017 and encouraging Aon United decisions that accelerate growth by bringing the best of the firm to our clients. So, a series of moves around leadership and the single brand. You saw us announce that we'd be again retiring the remaining business unit brands, primarily Aon Risk Solutions and Aon Benfield, following on a similar step with Aon Hewitt in 2017. I would tell you we’re very excited about the prospect of 50,000 Aon colleagues going to market as Aon, representing our priority to address client opportunities and innovation and really creating more distinctive solutions. This series of actions reflects our commitment towards a single brand, around Aon. Finally, you saw movement around innovation and structural movement. We created leadership capacity to drive more effort towards our new Data and Analytics offerings; we expanded John Bruno's role to become CEO of Data and Analytics services. Again, all designed to focus on investments and strengthen our innovation agenda, driving long-term growth. At Aon, this is what it's all about: long-term growth. The idea of leading Aon United. For us, this is well beyond improving the value and the power of this ethic. We see very clearly numerous examples of the economic leverage embedded in this pursuit. So, our leadership focus and what you’re seeing us do is how we deliver this more consistently and upscale across the firm. We believe this is highly relevant for a call like this, with our long-term partners, as leading Aon United is a source of client value. It's also very compelling for our colleagues, becoming a magnet to attract and retain talented leaders. We've been laying the foundation for Aon United for over a decade, evolving our portfolio, investing in new content capability, bringing those pieces closer together through programs like Aon Client Promise, which we’ve discussed before, among others. But it’s really just in the last few quarters that we’ve truly entered the era of Aon United, taking structural changes to bring that about. Again, to illustrate, let me provide an example discussed last week with our colleagues at a large U.S. health system. Imagine we’re in the room with the risk manager and our commercial risk team. Historically, this client has been great, but through the Aon Client Promise, our team began to understand their strategy and desire to seek payments based on outcomes—outcome-based payments. This represents a substantial trend that this client aims to lead in, and obviously, a series of significant operating challenges lie ahead. However, our team listened and stepped back to gather capabilities from around the firm. They included reinsurance colleagues into the conversation, and after a few hours, it was clear that if our client succeeded in this, they would inject greater volatility into their business model. While they may initially see success, the risk factors later on could greatly impact the hospital's operation. We engaged with them, and they expressed significant concern, wanting to know what we could do. In the end, our reinsurance colleagues provided analytics to model the risk and develop solutions for potential risk transfer. Essentially, we transitioned from a risk discussion to a strategic discussion. The collaborative efforts of our colleagues transformed the entire conversation with this client. There’s significant excitement among our colleagues about serving this health system in a much broader manner. Our clients are thrilled about the possibilities, which undoubtedly strengthens our original relationship. This is just one reflection of how the leadership enabled by Aon United can drive value. In terms of financial impact, I want to highlight three overarching points from the first half of the year. First, we see continued momentum. This is evident in our accrual results, and we are more confident than ever that we will run—or exceed—our original EPS forecast of $7.97 for the year, which has been highlighted by a Q2 performance of 5% organic growth, margin expansion of 130 basis points, EPS growth of 31%, and free cash flow growth of 17%. Next, we plan to continue investing to generate long-term growth, supported by our strong balance sheet and significant free cash flow. Leading Aon United at scale is projected to translate into stronger organic growth, and we are continuing to invest in inorganic opportunities that allow us to innovate faster on the topics most significant to our clients. Finally, I want to give you two examples. One occurred with the World Bank cap I mentioned in the last call, illustrating the impact of Aon United behavior. Connecting with the World Bank to protect Chile, Colombia, Mexico, and Peru from earthquake risk—something that was previously unaddressed. It required us to rally leaders from each of these countries along with the World Bank. The analytic capabilities we had in hand were vital, but they were insufficient without established relationships in each country, including the World Bank's. It was once this entire group convened that we engineered an innovative solution—a $1.4 billion bond that the World Bank reinvests into the country, strengthening their economy while safeguarding them against a previously unprotected risk. This example embodies the client leadership we aspire to achieve, enhancing relationships and creating new opportunities. Lastly, it is essential to underscore the ongoing productivity improvements from our global business services model, which continues to enable additional investments in emerging client needs like cyber and intellectual property. A series of outcomes from the quarter and the first half of the year reinforce the momentum we wish for you to understand. This context underlines that Aon United is about growth. So, we consistently communicate to our team that Aon United equals growth. As we drive this set of behaviors on behalf of our clients, positive outcomes emerge. Client leadership, increased retention, new client opportunities, and innovation result from this. While describing this concept is straightforward, replicating it is especially challenging in our industry. I express my gratitude to our team for embracing these opportunities and am excited about the progress we’ve made in these newly expanded roles over the past quarter and what it means for Aon’s future. I wanted to give everyone a different perspective on this topic, something we normally wouldn't discuss on this call but is fundamentally important to our firm's long-term growth. I aim to provide context to illuminate the results in perspective. With this high-level summary in mind, I would like to invite Christa to share a few thoughts before we open the floor for your questions.

Thanks so much, Greg, and good morning, everyone. In the spirit of this new format, I will cover the key metrics and then discuss how we’re driving operating leverage and investing in Aon, both organically and inorganically. The steps we’re taking and our strong progress so far continue to reinforce both our short- and long-term performance targets. Our performance in the first half reflects organic revenue growth of 4%, an acceleration from 3% in the first half of 2017. In addition to accelerating organic growth, mergers and acquisitions are continuing to contribute to improving the mix and driving total growth of 11% for the first half of 2018. Adjusted operating margins increased 200 basis points year-to-date, surpassing our historic average of 70 to 80 basis points a year over the last 10 years. Accelerating revenue combined with margin expansion is delivering operating income growth, which was exceptionally strong at 20% year-to-date, with core operating income growth reflecting half of the performance. EPS growth of $0.28 year-to-date positions us firmly on track to exceed our short-term target of $7.97 in earnings per share for 2018. Lastly, reported free cash flow decreased by $52 million year-over-year, driven by increased restructuring, reflecting that this is our peak year for restructuring cash usage. Adjusting for restructuring, underlying free cash flow grew 17% year-over-year, reinforcing our commitment to double-digit free cash flow. This is even stronger when combined with the 6% reduction in shares outstanding. Overall, the strong financial performance and long-term outlook are supported by the investments we’re making in our operating model in an Aon United way, as Greg described. Through the creation of our next generation global business services model, we’re achieving greater scalability, productivity, and operating leverage. One example is the consolidation of our North American call centers across our solution lines. We implemented a single industry-leading cloud platform with global reach, resulting in higher support for clients, better flexibility in managing capacity, and cost savings of approximately $10 million annually. Another example is consolidating our procurement spend globally. We now manage approximately 80% of our spend—or $2 billion—across nine major categories in four regional hubs, up from about $1 billion across four categories in our two largest countries. To achieve this, we implemented a cloud-based payment solution across 60 countries, supported by an offshore model, and this cloud platform is providing us greater insights into total spend to manage it more effectively over time. As a result, we’ve delivered $30 million of value in 2018 from these initiatives. These are just two examples of the long-term margin expansion we can expect to continue through productivity improvements from our single operating model and the remaining savings from our restructuring program. We are also making both organic and inorganic investments to shift our portfolio towards higher growth, high-return-on-capital areas. We do this with a strong discipline regarding capital allocation and maximizing return on invested capital. An example is in our delegated investment management business, where we have added over 50 colleagues and deep research capabilities in our core strength areas of defined benefit and defined contribution, while also investing and expanding capabilities in broader asset pools like insurance, sovereign wealth funds, and the nonprofit arena. This is driving double-digit organic growth through new client wins while also driving significant inorganic growth with the acquisition of Townsend. Since inception, our assets under management have grown from $0 to over $150 billion, driven by strong performance, transparency fees, and innovative solutions for our clients. Another significant investment comprises the $950 million we invested in share repurchases in the first half of 2018. This remains the highest return on capital opportunity across Aon, reflecting our valuation based on free cash flow growth over time. In summary, accelerating revenue growth, greater operating leverage, and continued working capital improvements will enable us to deliver double-digit free cash flow growth. This combination of free cash flow growth, alongside a reduction in total shares outstanding, will drive significant long-term shareholder value creation. With that, I will turn the call back to the operator for questions.

Hi, good morning, and thank you for the new format. Given your comments on the growth initiatives in Aon United, where do you see the long-term organic growth profile of the company over time? I mean, clearly a 4% organic growth year-to-date; you’re growing faster than the global economy, but where do you see that spread headed over the long term?

First of all, Sarah, I hope you like the format. I would love to have your comments and thoughts on how we can make it more helpful to you, but again, we are trying to provide a little more perspective on sort of the long-term underpinning of what drives our results. The idea of Aon United is at the core of your inquiry. For us, Aon United signifies growth. It fundamentally relates to accelerating organic growth, complemented by M&A as a strong engine of growth. This idea of Aon United emanates from an understanding of client needs. Clients have articulated to us how their needs are evolving. When we bring our firm together effectively, it proves to be very powerful. We've undertaken various initiatives to reinforce this organically around the firm. Programs like the Aon Client Promise or the Aon Impact model articulate how our colleagues conduct business. Recent structural initiatives represent the new developments this quarter regarding how we’ve accelerated these matters, which underpin organic growth. Our expectations are for continued progression; over the last four years, we’ve seen organic growth rates of 3% and 4%, and we anticipate sustained momentum.

Okay, great. Thanks. And just the expense savings; you have achieved $250 million to date and you target $300 million for '18. Should we expect a meaningful slowdown in the savings in the second half of '18, or are you running ahead of schedule, or should we consider that ultimate target of $450 million to be possibly conservative?

Sarah, what we would say is that where we’re at year-to-date gives us strong confidence in our ability to deliver the $300 million in savings in 2018 and the $450 million in savings in 2019. We are very pleased with the progress made so far, and we're not providing updates to our guidance for this year or next.

Thank you and good morning. Thank you for the refreshing format. A follow-up to Sarah's question on organic growth; you've seen acceleration. Could you elaborate whether the macro environment has aided this growth? And going forward, do you expect your growth acceleration to be dependent on further macro improvements, or is it intrinsically self-driven?

Look, Kai, as we’ve stated previously, our strategy is not reliant on market conditions. We depend heavily on understanding client needs and adapting to those needs. Our successes have consistently demonstrated this quarter-after-quarter. Regarding Sarah's question, we now believe we have the mechanisms in place to foster acceleration. While the market conditions present modestly positive exposures and average pricing remains flat, this isn't purely about the market; it's about enhancing our client relationships, retaining existing clients, as we call it, rollover. What we have now reflects an effort to build that profile. Specifically, we've identified notable momentum in commercial risk, reinsurance, health, and retirement sectors.

Okay. That's great. Regarding margin expansion; I hope you can address three points. Firstly, the 130 basis point margin expansion in the second quarter was primarily driven by cost savings of 160 basis points; however, there wasn't much operating synergy or leverage given that organic growth was only 5%. Secondly, in second half of the year, since incremental cost savings may decrease considerably compared to the first half, does that imply weaker margin expansion? Lastly, you mentioned some drag from the recent mergers and acquisitions; would you be able to provide EBIT-like figures regarding that?

Certainly, Kai. To clarify, we saw a 130 basis point margin expansion in Q2, and year-to-date, we’re up 200 basis points in margin. In any quarter, you must consider some underlying drivers like restructuring and foreign exchange. Additionally, we faced a negative impact of about 60 basis points from M&A and 30 basis points from FX within the quarter; this must be acknowledged along with the investments we're executing for growth. While stripping out these items is easier, we overall manage margins for the year. Our confidence remains strong about our full-year margin expansion, which we expect to bring continued margin improvements across 2019 and beyond. The margin expansion for 2018 will be driven by accelerating organic revenue growth, mix shift, and operational leverage, stimulated by restructuring and productivity improvements.

Thank you for the details. One last question, if I may, regarding your new model; any insights from business leaders on how day-to-day operations have changed compared to previous quarters? Moreover, while you speak about the advantages, are there any potential drawbacks or risks associated with implementing this new model?

They aren't on the call today, but what we plan for next time is to focus on the operational implications of Aon United. Eric and Michael will discuss how they are leading and managing it alongside the opportunities within the market, both positive and the challenges encountered. You’ll find the opportunity for us is immense. Engagements with clients based on their needs continue to be significant. Even if there’s no immediate commercial outcome, clients view us differently. Delivering Aon United capabilities leads to change in client perception and, ultimately, economists change and growth follows. You’ll hear more from them through the next call.

Good morning. I have a clarification point; Christa, the 30 basis points in E&O timing and the 60 basis points in M&A drags on margins; were these figures year-to-date or specific to the quarterly performance?

These were specific to the quarterly performance, Yaron.

Got it. Looking at the second half of this year, assuming you’re facing tougher organic growth comparisons, alongside potential FX headwinds, is margin improvement achievable without considering restructuring expenses?

Yes, it is, Yaron. As we evaluate 2018 and look ahead to the second half, we expect margin expansion through organic growth, continued investment in M&A, and a shift towards higher growth, potential margin areas within the portfolio. The operational leverage we receive in our business from restructuring and the Aon United operating model contributes further to margin growth.

Moreover, Yaron, we continue building momentum across organic growth. Reflect on the first half of the year as very positive. We anticipate ongoing progress in the second half; certain areas, such as reinsurance, experienced growth of 8% during the quarter and favorable trends in the first half. Note that we will be facing comparably high performance metrics in the second half. There were specific events last year that may not occur this time, which could create slight headwinds. However, we are committed to pushing forward and driving momentum concerning organic growth.

Christa, you suggested M&A as a source of margin improvement in the second half; does this refer to timing for integrating previous acquisitions, or are there other components at play?

That's correct. My primary point is to avoid overemphasizing M&A achievements during any quarter. I see M&A investments as linearly beneficial to margin expansion over time. Incremental benefits will build up as we integrate businesses and drive margin growth over the full year.

Good morning, everyone. Free cash flow peaked around $2.1 billion in 2016. Do you think you'll return to that figure by 2019? What’s your outlook for guidance? Once you reach that core level, will free cash flow grow at a higher rate than EPS or will it align more closely with operating earnings?

We are not providing a new cash flow target, Adam. We’re focused on driving free cash flow at double-digit levels. Year-to-date, we are pleased to see a 17% growth in underlying free cash flow. As for calendar year 2018, expect to see free cash flow accelerate due to restructuring cash use declining. Free cash flow growth, in the long term, will be driven primarily by operating income growth and improvements in working capital. We foresee freeing around $500 million within our balance sheet primarily related to receivables over the next couple of years to enhance cash flow growth and drive a notable increase in free cash flow per share.

Hi, good morning. A numerically specific inquiry: regarding the $103 million of legacy litigation removed from the adjusted earnings in the quarter; could we have more context on this matter? Should we expect similar impacts on earnings moving forward?

While we can't explore specifics regarding the litigation involved, we want to reassure you that we have implemented numerous steps to decrease volatility at Aon over time. We've established limits on liabilities, procured additional insurance, and upon filing our Q later today, you'll notice we've reduced estimated losses from disclosed litigation from $300 million to $100 million, marking substantial progress in reducing legacy litigation as we pursue growth across the firm.

Okay. Regarding margin impact; you pointed out the quarter saw a 60-basis point reduction from M&A and a 30-basis point decrease from currency, leading us to contemplate potential impacts over the next two quarters. How should we perceive margin impacts from currency driving overall results? Additionally, based on your insights, should we anticipate an easing of M&A-related impacts on margins over the coming quarters?

Elyse, the first point is currency's impact on margins is challenging to forecast with precision. EPS-wise, anticipate a $0.03 impact in Q3 and Q4, driven mainly by Latin America. Regarding the M&A negative impact of 60 basis points in Q2, we expect that to neutralize throughout the year. M&A integration generally imposes a negative margin influence during the initial year; however, integrating businesses will positively contribute to margins longer term as we invest in high-revenue growth areas.

Good morning. Could you provide insights into the organic growth for the reinsurance segment? It appears that pricing may be weak, yet customers are possibly buying more. Is there a shift in market share amongst the brokers?

Overall market conditions have been challenging, with ample capital available for us to serve clients beyond those areas. Despite that, we are experiencing solid fundamental results in reinsurance, evidenced by success in treaty, insurance-linked securities, and an ongoing series of net new business wins. Remember that just a couple of years ago, discussions revolved around concerns on growth. Our team's efforts have proven fruitful, maintaining net new wins even in challenging pricing climates. This organic growth illustrates our commitment, and it serves as a testament to Aon's enduring strength.

Thank you. As a brief follow-up, clarify—concerning the buybacks, given your year-to-date activity purchasing around $50 million and dividend payments close to $100 million, coupled with around $50 million for acquisitions; collectively, that's roughly $1.2 billion in outlay compared to the $300 million cash flow. It prompts the question of whether you'll reduce buybacks in the latter half of this year based on cash flow sources and intended uses.

That’s a pertinent question, Kai. As we approach cash flow this year, I remind you that Q3 and Q4 have historically been our strongest cash flow quarters. Therefore, we expect a more robust performance in cash flow from operations. As we allocate cash towards various activities, we will prioritize those with the best ROIC. Our plan is to continue investing in buybacks, as it represents our highest return on capital strategy. We will also invest in M&A and organic growth opportunities due to the substantial returns they can yield.

One more query regarding your full-year guidance of $7.97; given you initially projected this value at the year's outset, should we not expect an uptick of approximately 2% based on the potential benefits from foreign exchange and reduced overall tax rates?

Indeed, we generally refrain from updating guidance; as we illustrated when we announced the transaction in May 2017, it provided substantial shareholder benefits. This transition left Aon with a portfolio maximizing revenue growth, margin potential, and impressive returns on capital, while also yielding considerable cash benefits to stakeholders, around $3 billion. Since then, we’ve aimed to ensure clarity around our confidence in exceeding EPS targets for 2018. EPS is up 28% year-to-date, and we remain confident in exceeding $7.97 without updating our guidance.

Thank you all for your participation in today's call. We've taken a slightly different approach this time in terms of format, aiming to provide insights about the long-term efforts that will impact Aon's success. We appreciate your feedback on the new structure and welcome any suggestions for future calls. We look forward to connecting with you in the next quarter.